1. The Balance of
Payments,
Exchange Rates,
and Trade Deficits
Chapter 38
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives
• How currencies are exchanged
• Balance sheet for recording
international payments
• How exchange rates are
determined
• Flexible vs. fixed exchange
rates
• Causes and consequences of
trade deficits
38-2

3. International Transactions
• International trade
–Buy/sell current goods or services
–Imports and exports
• International asset transactions
–Buy/sell real or financial assets
–Buy stock
–Sell your house to a foreigner
• Requires currency exchange
38-3

4. Balance of Payments
• Sum of international financial
transactions
• Current account
–Balance on goods and services
–Net investment income
–Net transfers
–Balance on current account
38-4

5. Balance of Payments
• Capital and financial account
–Capital account
–Financial account
• Balance of payments accounts
sum to zero
• Current account deficits generate
asset transfers to foreigners
• Official reserves
38-5

6. U.S. Trade Balances
Goods and Services, Select Nations, 2007
SurplusDeficit
Australia
Belgium
Canada
China
Germany
Mexico
Netherlands
+10.0
-67.0
-45.3
+9.8
-256.6
-77.3
+14.3
Source: Bureau of Economic Analysis
-10-20-30-40-50-60-70-250 10 20
Japan -85.0
38-6

7. Flexible Exchange Rates
• Demand for pounds
• Supply of pounds
• Market equilibrium
• Increase in dollar price of pounds
–Dollar depreciates
–Pound appreciates
• Decrease in dollar price of pounds
–Dollar appreciates
–Pound depreciates
38-7

8. Q
0
DollarPriceof1Pound
Quantity of Pounds
P
Flexible Exchange Rates
The Market for Foreign Currency (Pounds)
D1
S1
Dollar
Depreciates
(Pound
Appreciates)
Dollar
Appreciates
(Pound
Depreciates)
Exchange
Rate: $2 = £1
$2
$3
$1
Q1
38-8

9. Flexible Exchange Rates
• Determinants of exchange rates
• Factors that shift demand/supply
–Changes in tastes
–Relative income changes
–Relative price-level changes
•Purchasing-power-parity theory
–Relative interest rates
–Relative expected returns on
assets
–Speculation
38-9

10. Q
0
DollarPriceof1Pound
Quantity of Pounds
P
Flexible Exchange Rates
The Market for Foreign Currency (Pounds)
D1
S1
Exchange
Rate:
$2 = £1
$2
$3
$1
Q1
D2
Exchange
Rate:
$3 = £1
Balance
Of Payments
Deficit
Q2
x a
b
c
38-10

11. Flexible Exchange Rates
• Eliminate balance of payments
deficit or surplus
• Disadvantages of flexible
exchange rates
–Volatility
–Uncertainty and diminished trade
–Terms-of-trade changes
–Instability
38-11

12. Fixed Exchange Rates
• Government intervention
–Use of reserves
• Trade policies
• Exchange controls and rationing
–Distorted trade
–Favoritism
–Restricted choice
–Black markets
• Macroeconomic adjustments 38-12

13. Exchange Rate Systems
• Gold standard 1879-1934
–Fixed exchange rate system
• Bretton Woods 1944-1971
–Fixed exchange rate system
indirectly tied to gold
• Managed float 1971-present
38-13

14. Managed Float
• Dependence on foreign
exchange markets
• Occasional intervention
• In support of managed float
• Concerns with managed
float
38-14

15. U.S. Trade Deficit
• Large and persistent
• Causes of trade deficits
–High U.S. growth (relatively)
–China
–Price oil
–Low U.S. saving rate
• Implications of trade deficits
–Increased current consumption
–Increased indebtedness 38-15

16. Speculation in Currency Markets
• Positive or negative influence?
• Contributes to currency market
fluctuations
• Self-fulfilling expectations
• Smoothing short-term
fluctuations
• Absorbing risk
• Futures market at work
• Positive role played overall
38-16

17. Key Terms
• balance of payments
• current account
• balance on goods and
services
• trade deficit
• trade surplus
• balance on current
account
• capital and financial
account
• balance on capital and
financial
• balance-of-payments
deficits and surpluses
• official reserves
• flexible- or floating-
exchange-rate system
• fixed-exchange-rate
system
• purchasing-power-
parity theory
• currency interventions
• managed floating
exchange rate
38-17